The Three Major Financial Statements: How They're Interconnected (2024)

The information found on the financial statements of an organization is the foundation ofcorporate accounting. This data is reviewed by management, investors, and lenders for the purpose of assessing the company's financial position.

Data found in the balance sheet, the income statement, and the cash flow statement is used to calculate important financial ratios that provide insight on the company’s financial performance and potential issues that may need to be addressed. The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. Together the three statements give a comprehensive portrayal of the company’s operating activities.

Key Takeaways

  • The information found on the financial statements of an organization is the foundation ofcorporate accounting.
  • Also referred to as the statement of financial position, a company'sbalance sheet provides information on what the company is worth from a book value perspective.
  • A company'sincome statementprovides details on the revenue a company earns and the expenses involved in its operating activities.
  • Thecash flow statementprovides a view of a company’s overall liquidity by showing cash transaction activities.

The Balance Sheet

Also referred to as the statement of financial position, a company'sbalance sheet provides information on what the company is worth from a book value perspective. The balance sheet is broken into three categories and provides summations of the company's assets, liabilities, and shareholders' equity on a specific date.

Generally, a comprehensive analysis of the balance sheet can offer several quick views. In order for the balance sheet to ‘balance,’ assets must equal liabilities plus equity. Analysts view the assets minus liabilities as the book value or equity of the firm. In some instances, analysts may also look at the total capital of the firm which analyzes liabilities and equity together. In the asset portion of the balance sheet, analysts will typically be looking at long-term assets and how efficiently a company manages its receivables in the short term.

There are a variety of ratios analysts use to gauge the efficiency of a company’s balance sheet. Some of the most common include asset turnover, the quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.

The Income Statement

A company'sincome statementprovides details on the revenue a company earns and the expenses involved in its operating activities. Overall, it provides more granular detail on the holistic operating activities of a company. Broadly, the income statement shows the direct, indirect, and capital expenses a company incurs.

Starting with direct, the top line reports the level of revenue a company earned over a specific time frame. It then shows the expenses directly related to earning that revenue. Direct expenses are generally grouped into cost of goods sold or cost of sales, which represents direct wholesale costs. Costs of sales are subtracted from revenue to arrive at gross profit. Gross profit is then often analyzed in comparison to total sales to identify a company’s gross profit margin.

Indirect expenses are also an important part of the income statement. Indirect expenses form a second category and show all costs indirectly associated with the revenue-generating activities of a firm. These costs can include salaries, general and administrative expenses, research and development, and depreciation and amortization. Together these indirect expenses are subtracted from gross profit to identify operating income.

The final category on the income statement factors in capital expenses. The last expenses to be considered here include interest, tax, and extraordinary items. The subtraction of these items results in the bottom line net income or the total amount of earnings a company has achieved.

Offering a great deal of transparency on the company’s operating activities, the income statement is also a key driver of the company’s other two financial statements. Net income at the end of a period becomes part of the company’s stockholders' equity as retained earnings.Net income is also carried over to the cash flow statement where it serves as the top line item for operating activities. Sales booked during the period are also added to the company’s short-term assets as accounts receivable.

On the income statement, analysts will typically be looking at a company’s profitability. Therefore, key ratios used for analyzing the income statement include gross margin, operating margin, and net margin as well as tax ratio efficiency and interest coverage.

The Cash Flow Statement

Thecash flow statementprovides a view of a company’s overall liquidity by showing cash transaction activities. It reports all cash inflows and outflows over the course of an accounting period with a summation of the total cash available.

Standard cash flow statements will be broken into three parts: operating, investing, and financing. This financial statement highlights the net increase and decrease in total cash in each of these three areas.

The operating portion shows cash received from making sales as part of the company's operations during that period. It also shows the operating cash outflows that were spent to make those sales. For example, the cash paid for rent, salaries, and administration.

The other two portions of the cash flow statement, investing and financing, are closely tied with the capital planning for the firm which is interconnected with the liabilities and equity on the balance sheet. Investing cash activities primarily focus on assets and show asset purchases and gains from invested assets. The financing cash activities focus on capital structure financing, showing proceeds from debt and stock issuance as well as cash payments for obligations such as interest and dividends.

A Comprehensive View

All three accounting statements are important for understanding and analyzing a company’s performance from multiple angles. The income statement provides deep insight into the core operating activities that generate earnings for the firm. The balance sheet and cash flow statement, however, focus more on the capital management of the firm in terms of both assets and structure.

Overall, top-performing companies will achieve high marks in operating efficiency, asset management, and capital structuring. Management is responsible for overseeing these three levers in a way that serves the best interest of the shareholders, and the interconnected reporting of these levers is what makes financial statement reporting so important.

The Three Major Financial Statements: How They're Interconnected (2024)

FAQs

How to answer how are the three financial statements connected? ›

Net income from the bottom of the income statement links to the balance sheet and cash flow statement. On the balance sheet, it feeds into retained earnings and on the cash flow statement, it is the starting point for the cash from operations section.

What are the three financial statements and how are they interlinked? ›

The income statement, balance sheet, and cash flow all connect to create the three-statement model. How? Changes in current assets and liabilities on the balance sheet are reflected in the revenues and expenses that you see on the income statement.

What are the three 3 standard financial statements and describe how they relate to one another? ›

The income statement illustrates the profitability of a company under accrual accounting rules. The balance sheet shows a company's assets, liabilities, and shareholders' equity at a particular point in time. The cash flow statement shows cash movements from operating, investing, and financing activities.

How are the main financial statements connected? ›

In summary, net income from the income statement flows to the top of the cash flow statement, which flows into the bottom of the balance sheet as retained earnings. Net income also impacts cash, which is reported at the bottom of the cash flow statement, which then flows into the top of the balance sheet.

How are the three financial statements connected in Quizlet? ›

How are the three financial statements linked? The Income Statement is linked to the Balance Sheet and Statement of Cash Flows through Net Income. Net Income flows to the Balance Sheet through the Retained Earnings account within Shareholders' Equity.

What are the three major financial statements explain? ›

The three main types of financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements together show the assets and liabilities of a business, its revenues, and costs, as well as its cash flows from operating, investing, and financing activities.

What is the basic 3 statement financial model? ›

What is a 3-Statement Model? The 3-Statement Model is an integrated model used to forecast the income statement, balance sheet, and cash flow statement of a company for purposes of projecting its forward-looking financial performance.

How are the balance sheet and income statement connected? ›

The balance sheet shows the cumulative effect of the income statement over time. It is just like your bank balance. Your bank balance is the sum of all the deposits and withdrawals you have made. When the company earns money and keeps it, it gets added to the balance sheet.

What are the three 3 main components of the statement of financial position describe each component? ›

The three main components of the statement of financial position are assets, liabilities, and equity, which are broken down into various categories. However, the way in which the statement is presented varies from company to company, depending on the types of assets, liabilities, and equity they have.

What is the major connection between the statements of financial position and performance? ›

Answer and Explanation:

The statement of financial performance uses information from the statement of financial position for its reporting. The Financial performance uses the assets, liabilities, and equity from the statement of position in its activity.

Which financial statement is most important? ›

Types of Financial Statements: Income Statement. Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.

What are the three financial statements that are forecasted? ›

A three-statement financial model, also called the 3 statement model is an integrated model that forecasts an organization's income statements, balance sheets and cash flow statements. It is the foundation on which we can build additional (and more advanced) models.

How are the balance sheet and cash flow statement connected? ›

The cash flow statement shows the cash inflows and outflows for a company during a period. In other words, the balance sheet shows the assets and liabilities that result, in part, from the activities on the cash flow statement.

What is the relationship between balance sheet and profit and loss account? ›

The Balance Sheet reveals the entity's financial position, whereas the Profit and Loss account discloses the entity's financial performance. A Balance Sheet gives an overview of the assets, equity, and liabilities of the company, but the Profit and Loss Account is a depiction of the entity's revenue and expenses.

Which 2 of the 3 financial statements is most important? ›

Another way of looking at the question is which two statements provide the most information? In that case, the best selection is the income statement and balance sheet, since the statement of cash flows can be constructed from these two documents.

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